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By Dirk J.J. Suringa, Esq.
Covington & Burling LLP, Washington, DC
In Notice 2010-92,1 the IRS and Treasury requested comments on whether covered asset acquisitions described in §901(m) should be treated as giving rise to a foreign tax credit splitting event under §909.2 Section 909 treatment in many cases would be more favorable than §901(m) treatment: §909 suspends the foreign tax credit until the income to which the foreign tax relates is taken into account, while §901(m) denies the credit altogether. Allowing §§909 and 901(m) to mix, however, would generate added complexity. For example, the IRS apparently is considering treating a covered asset acquisition entered into before the effective date of §901(m) as creating a foreign tax credit splitting event under §909 in post-effective date years. This approach would appear to be inconsistent with the congressionally intended effective date of §901(m). Expanding §909 at the expense of §901(m) still might be worthwhile if the guidance can be written in a way that applies §909 to a discrete set of covered asset acquisitions entered into after 2010. Interested taxpayers should weigh in on this issue.
Under §909, a foreign tax credit splitting event suspends a foreign income tax for U.S. tax purposes until the year in which the taxpayer takes into account the income related to the tax (the "related income").3 A foreign tax credit splitting event occurs when the related income is or will be taken into account by certain persons (covered persons) related to the payor of the foreign tax.4 If there is a foreign tax credit splitting event with respect to a foreign income tax paid or accrued by a §902 corporation, the tax is suspended for purposes of §902 or §960, and for purposes of determining earnings and profits under §964(a), until the income related to the tax is taken into account by the §902 corporation or a §902 shareholder.5
Although Notice 2010-92 focuses on pre-2011 split taxes and on deemed-paid credits claimed under §902 or §960, the Notice does give a first indication of how "foreign tax credit splitting event" and "related income" will be defined more generally. The Notice treats the following as foreign tax credit splitting events: (1) foreign reverse hybrids; (2) foreign consolidated groups taxed on the basis of combined income; (3) certain group relief arrangements involving disregarded payments; and (4) certain hybrid instruments.6 The Notice defines "related income" for the first two structures by reference to the income run through the splitter system. In the case of a foreign reverse hybrid owned by a controlled foreign corporation (CFC), for example, related income is CFC earnings attributable to the activities of the reverse hybrid that gave rise to income subject to tax under foreign law.7 For the third and fourth structures the Notice defines "related income" by reference to the amount of the loss, generated for foreign tax purposes by the structure, that is made available to offset income of a covered person.8 The Notice recognizes that further work on these definitions will be required, and it requests comments on several additional structures that might be considered to give rise to foreign tax credit splitting events, including covered asset acquisitions described in §901(m).9
Section 901(m) denies a foreign tax credit for the "disqualified portion" of the foreign income tax paid or accrued in connection with a covered asset acquisition. The disqualified portion of the foreign income tax is determined by reference to a formula. The formula attempts to isolate the amount of foreign tax attributable to income that is offset for U.S. tax purposes by the incremental cost recovery deductions produced by the covered asset acquisition. To define the term "covered asset acquisition," the statute lists certain transactions that are assumed to give rise to cost recovery deductions under U.S. law but not foreign law, including a qualified stock purchase to which §338(a) applies, the acquisition of an interest in a partnership subject to a §754 election, and any transaction treated as an acquisition of assets for U.S. tax purposes but as an acquisition of stock for foreign tax purposes. Unlike §909, §901(m) denies the foreign tax credit for the disqualified portion of the foreign income tax but continues to allow a deduction for the foreign tax. 10
Both §§909 and 901(m) target the separation of creditable foreign taxes from the associated foreign income. The focus of §909 is basically a timing benefit: the acceleration of a foreign tax credit or deduction when the taxpayer, through a related person, can defer the accompanying U.S. tax cost of including the foreign income subject to tax. Section 901(m), by contrast, targets the foreign tax credit benefit that arises when cost recovery deductions reset for U.S. tax purposes but not for foreign tax purposes. Section 901(m) assumes that the benefit would be permanent, and so disallows it permanently. The two provisions thus could be said to overlap to the extent a transaction that resets cost recovery deductions for U.S. tax purposes but not for foreign tax purposes gives rise to related income of a covered person. 11 Suspension of the foreign tax in such a case would make more sense than outright denial because the taxpayer at least in theory could take the related income into account for U.S. tax purposes. The strength of this argument would appear to depend on whether — and where — there is related income for §909 purposes in a covered asset acquisition.
If an unrelated person takes the related income in a covered asset acquisition, then there would appear to be little room for applying §909. For example, if a U.S. corporation or its CFC acquires, subject to a §338(g) election, a target foreign corporation from a foreign corporation that is not a CFC or a PFIC, then the deemed-sale gain that produces the §338 basis step-up generally occurs outside the U.S. tax system. 12 The deemed-sale gain would be a logical choice for the related income, in §909 parlance. If it is, the covered asset acquisition would not give rise to a foreign tax credit splitting event, absent some very unusual facts, because the related income would not be taken into account by a covered person. 13
Other types of covered asset acquisitions, however, might also technically qualify as foreign tax credit splitting events. For example, assume that CFC1 sells a foreign disregarded entity (FDE) to related CFC2 for arm's-length consideration. If the sale is treated for U.S. tax purposes as an asset sale and for foreign purposes as a stock sale, then §901(m) by its terms would deny the credit for the portion of the foreign tax attributable to any U.S. basis step-up arising from the transaction. The IRS appears to be considering treating the earnings of CFC1 attributable to gain from the deemed asset sale as related income for purposes of §909. If §909 were to apply, then the disqualified portion of the taxes could be suspended until CFC1 distributes those earnings, rather than denied. This result might be the right policy answer under §901(m). Further assume that the assets of FDE are passive, such that their deemed sale produces foreign personal holding company income currently includible by the U.S. parent of CFC1. One might not expect §901(m) to deny in future years foreign tax credits attributable to additional basis that has been "purchased" with a current U.S. tax inclusion.
If the IRS and Treasury do decide to expand §909 to cover certain covered asset acquisitions, they should do so only for covered asset acquisitions entered into after the 2011 effective date of §901(m). Congress set forth in great detail specific effective dates for §§901(m) and 909, 14 including very carefully calibrated transition rules for the retroactive application of §909 — as illustrated by Notice 2010-92 itself. Under the statutory scheme, Congress intended to allow the foreign tax credit benefits associated with what would otherwise be the disqualified portion of the foreign taxes paid or accrued after 2010 with respect to a covered asset acquisition entered into before January 1, 2011. If the IRS and Treasury do decide to overlap the rules, they could carve out a transition rule for pre-2011 covered asset acquisitions. In the meantime, interested taxpayers should weigh in on these issues.
This commentary also will appear in the February 2011 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see DuPuy and Dolan, 901 T.M., The Creditability of Foreign Taxes -- General Issues and in Tax Practice Series, see ¶7150, U.S. Persons—Worldwide Taxation.
8 See id. §4.04 and 4.05. In the case of a U.S. debt hybrid instrument, the related income is defined by reference to the amount of the interest income recognized for U.S. tax purposes, which corresponds to the amount of interest expense taken into account for foreign tax purposes.
13 See generally §338(h)(3)(A)(iii) (excluding related-party transactions from the definition of a qualified stock purchase). The IRS and Treasury have the authority to define "covered person" to include unrelated persons (see §909(d)(4)), but expanding the scope of §909 to cover unrelated-party splitters would not appear to be their first order of business.
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